That leases and other rights over non-depreciable assets be taxed under
a general framework which more closely reflects the economic substance of the
arrangements.

In Chapter 10 of A Platform for Consultation, the Review canvassed revised
arrangements to put the taxation of leases and other rights over non-depreciable assets on
a basis that more closely reflects the changes in value of the assets and liabilities
associated with the rights.

Certain problems with the existing taxation of rights were outlined in A Platform
for Consultation (page 269).

 In the hands of the grantee, many expenditures on rights are
currently not deductible except as a capital loss at the end of the right. Examples
include franchise fees, lease premiums, restrictive covenants and some statutory licenses.

 Such rights are treated as the creation of new assets by the
grantor and up-front payments to the grantor are taxed on receipt.

 In other cases, taxpayers are able to gain unwarranted tax benefits
by structuring the profile of payments for a right so that the profile differs
significantly from that of the benefits obtained from the right.

Submissions to the Review supported straight line write-off of expenditure over the
period of a right that is likely to provide broadly uniform annual benefits -- under
the proposed `deemed benefits' approach outlined on pages 274-275 of A Platform
for Consultation.

Concerns were raised however, over the complexity of the proposed `implicit benefits
approach' canvassed in A Platform for Consultation (page 274)as a method of
taxing rights where the annual benefits from the rights vary depending on a range of
circumstances. Concerns were also raised in submissions about the potential for balancing
charges on the granting of rights to impose taxation on unrealised gains associated with
the asset underlying the rights -- under options canvassed in A Platform for
Consultation (pages 278-80).

The proposed framework for taxing rights will reduce the current inconsistency and
distortionary nature of the law while also addressing concerns raised in submissions.
Significant exclusions for `routine' rights -- Recommendation 10.2(a) --
will mean that the taxation of many rights which are currently taxed reasonably will be
unaffected by the changes, reducing the compliance burden of taxpayers. Beyond `routine'
rights, the tax treatment of a right will recognise the assets and liabilities involved:
the nature of the asset (the right) acquired by the grantee, which affects the tax value
of the underlying asset retained by the grantor; and, if the right is not paid for
entirely up-front, the stream of payments for the right, which represents an asset to the
grantor and a liability to the grantee.

The grantee will attract write-off to reflect the declining value of the right to the
grantee (Recommendation 10.3). Simple straight line write-off will apply where the right
is likely to decline steadily in value (reflecting, say, broadly equal benefits from
access to the underlying asset).

The grantor will be subject to a balancing adjustment on disposal of rights where the
right represents a permanent disposal (Recommendation 10.4). The grantor will also be
subject to a balancing adjustment where the disposal is not permanent but the right lasts
longer than 10 years (Recommendation 10.5). In each case, a balancing adjustment will
arise to the extent that there are previously unrealised changes in value associated with
that part of the underlying asset associated with the right. The balancing adjustment
results from a difference between the reduction in tax value of the underlying asset and
the up-front value of the payments for the right.

For rights which are not permanent disposals (where the grantor regains access to the
underlying asset on expiry of the right), the tax value of the underlying asset will
recover at the end of the right to its level prior to the sale of the right
(Recommendation 10.5). The profile of recovery will generally mirror the write-off profile
of the grantee's right. This treatment is in line with that recommended for part disposals
of benefits or obligations associated with financial assets and liabilities
(Recommendation 9.8).

These changes will significantly improve the tax treatment of rights. Up-front payment
for short term rights, for example, will become deductible to the grantee and assessable
to the grantor over the term of the right. Distortions and inconsistencies, as well as tax
benefits and disadvantages from the structuring of payments for rights, will be removed or
reduced significantly.

Cameos 10.2 and 10.4 on pages 272 and 277, respectively, of A Platform for
Consultation illustrate the recommended treatment of the grantee and grantor. Some
further examples are provided here to illustrate the proposed treatment of different
rights.

(a) That rights be taxed on the basis of payments that are due, where
regular periodic payments are required to be made which `broadly approximate the benefits
received in each period' under the right.

Personal services

(b) That contracts relating to the provision of personal services by
individuals (including through personal service companies) be taxed on a receivables
basis.

A Platform for Consultation (page 273) emphasised the importance of new
arrangements for taxing rights being easy to apply and not imposing high compliance costs
on taxpayers, especially in the majority of cases where payments are not structured to
obtain tax benefits.

The payments for most `routine' rights will be assessed when they are due regardless of
the period of the right. That will apply where regular payments are made for the right
which `broadly approximate the benefits received in each period' under the right. It is
expected that this will include most leases of land and service contracts where there are
no prepayments.

To simplify compliance, leases of realty will be treated as being single leases (rather
than multiple leases) over non-depreciable assets, providing that they do not involve the
use of depreciable assets the value of which exceeds the limits set out in Recommendation
10.7(c). Leases of realty which include buildings and other depreciable assets in excess
of those limits would be divided into a lease of depreciable assets covered by
Recommendation 10.8 and a lease of non-depreciable assets.

Rights will be treated as `routine' where, in line with ordinary commercial practice,
the payments are commensurate with the benefits received in each period -- such as
equal payments or payments that escalate over the period of the right in line with the CPI
or market expectations (such as realty rents). Payments will also need to be specified as
being required at least yearly. Rights for a period of less than one year will also be
treated as routine rights.

Contracts relating to the provision of personal services by individuals (including
through personal service companies), such as sports signings, `golden hello' payments and
endorsements -- will also be treated in a similar way to routine rights and taxed on
a receivables basis.

Rights which are taxed as being `routine rights' will not be subject to Recommendations
10.3, 10.4 and 10.5.

That grantees of `non-routine' rights that are not perpetual receive a
write-off consistent with the profile of reduction in value of the right (in turn
reflecting the nature of the underlying asset):

(i) where the right represents a steadily wasting asset to the
grantee -- straight line write-off over the period of the right;

(ii) where the wasting of the right depends on the rate of exploitation
of the underlying asset by the grantee -- write-off based on the actual rate of
usage; or

(iii) in other cases -- write-off based on a demonstrated
reasonable estimate of the annual rate of change in the benefits provided by the
underlying asset.

Many expenditures on rights are currently not deductible except as a capital loss at
the end of the right (when it has no value). The proposed arrangements will give a
deduction to the grantee based on the broad profile of reduction in value reflecting the
nature of the asset underlying the right. The write-off will apply over the period of the
right or the period over which the associated benefit will be taken, where shorter.

Where the grantee takes the benefits under a right on a roughly equal basis over the
period, straight line write-off broadly reflects the economic and commercial reality
particularly if the right is not of long duration. Straight line treatment is therefore
proposed in a range of cases, including leases of land. Nevertheless, providing straight
line treatment is not appropriate where the grantee can structure the benefits from the
right or for long dated leases of land and property, especially where the benefits may be
expected to increase rather than remain constant over the lease.

Straight line write-off would not be appropriate where the grantee takes the benefit at
a point the grantee determines; for example in the case of a right to take something from
another's land (profits à prendre). It would create both structuring opportunities
in some situations and disadvantage taxpayers in others. In such cases, the grantee's
write-off will be based on the actual rate of usage.

The change in value of the benefits from the right may be reasonably predictable by the
grantee and grantor at the beginning of a right. In such cases, the grantee will be able
to apply write-off over the period of the right on the basis of an up-front estimate of
the expected change in value of the benefits where that estimate is reasonable and
mutually agreed.

The longer the right the less straight line write-off would approximate the change in
value of the benefits from a right over say land and property. In these circumstances
straight line treatment would produce significant arbitrage opportunities. To address this
by taxing rights over say 50 years as a sale of the underlying asset would introduce
an arbitrary boundary line. An alternative would be to tax the change in the expected
benefits -- say moving in line with the CPI -- for rights of long duration.

Another possibility would be to split the taxing of non-routine leases over land (crown
leases in particular) into a routine element and a non-routine element. Many pastoral
leases involve an up-front premium and annual rent. Treating the annual rents as `routine'
and the premium as `non-routine' could result in simpler treatment, reduce arbitrage
opportunities and smooth the routine/non-routine borderline.

While recognising these considerations, the Review opted for the practical approach
reflected in the recommendations.

Restrictions on the ability to deduct payments which relate to benefits enjoyed beyond
the period of the right, such as where options exist, will be necessary to remove
avoidance possibilities -- for example, where an agreement turns a series of non-perpetual
rights into a perpetual right.

If the grantee pays for the right with a stream of payments, the grantee's write-off
will be based on the present value of the payments stream. The fall in the value of the
stream of future payments (an outstanding liability of the grantee) will be added to the
taxable income of the grantee over the payment period.

Where future payments for the right include royalties that are not certain (subject,
for example, to the size of the benefits extracted under the right), such royalties will
not be included in the determination of the present value of the payments stream. They
will be taxed on a receivables basis. This removes a potential for double taxation of
rights under the current law.

Cameo 10.4 on page 277 of A Platform for Consultation illustrated the
recommended treatment for both the grantee and grantor of a five-year right over a
non-depreciable asset where the payments for the right are spread over the first
three years. Straight line write-off over the five years applies to the grantee and
the grantee is also taxed on the fall in annual value of the payments.

Cameo 10.2 on page 272 of A Platform for Consultation illustrated the
recommended treatment for both the grantee and grantor of a right over the same
asset -- but where the payment for the right is up-front and the grantee and grantor
agree on a profile of equal benefits from the asset over the five years of the right.

That non-routine rights which in substance represent the full economic
disposal of an asset or the permanent disposal of part of an asset be treated as being a
disposal (or part disposal) of the asset by the grantor and acquisition by the grantee.

Many rights in substance represent the economic disposal of assets, either because the
right is effectively in perpetuity or because the grantor otherwise does not regain an
asset at the end of the right. Examples are rights to remove gravel or slate from someone
else's land. These rights differ from other cases, in which the grantor regains the use of
an underlying asset at the end of the right. (Rights relating to the removal of timber are
covered under Recommendation 10.5 as these rights can be granted several times in
succession over the same piece of land.)

Taxing such rights as disposals of an asset by the grantor reflects the economic
substance of the transaction. This represents a change from the current treatment whereby
many rights are treated as representing the creation of a new asset rather than a part
disposal of an existing asset.

The tax value of the portion of the underlying asset being disposed of often cannot be
separately identified. In those cases, the tax value of the underlying asset prior to the
disposal will be reduced by the ratio of the present value of the payments for the right
to the market value of the underlying asset at that time. Any excess between the payment
for the right and the reduction in tax value (a gain) will add to taxable income, and vice
versa for a loss.

These gains or losses will attract capital gains treatment on the same basis as sale of
the underlying asset. Thus, where the right is granted over a pre-CGT asset, the right
will be treated as being the part disposal of the pre-CGT asset.

Rights where there is no specific underlying asset (such as franchises and some
restrictive covenants) will be treated as being the disposal of an asset with a tax value
of zero plus any undeducted attributable costs. The disposal should not attract the
capital gains treatment or small business capital gain concessions. In a realisation based
tax system, not all assets are recognised on creation, or as their value builds up over
time (often on the basis of expenditures that are immediately deductible for income tax
purposes).

To the extent that the right is not paid for up-front, the fall in the tax value of the
stream of future payments will reduce the grantor's taxable income over the period
involved. The stream of payments is an asset to the grantor with an initial tax value
equal to the present value of those payments. This matches the treatment of the grantee.
(This treatment applies also in the case of rights not representing disposals.)

Example 10.1
Rights to remove gravel from someone else's land

A buys
some land and gravel deposits for $80,000 and subsequently issues a right to B to remove
the gravel in return for a payment of $10,000. The land and gravel are jointly valued at
$100,000 at the time that the right is granted.

The tax value of A's land is reduced by 10 per cent of $80,000
($8,000) as effectively 10 per cent of the value of the land has been realised. The
grantor is therefore taxed on a capital gain of $2,000 -- the receipt of $10,000 less
the decline in tax value of $8,000. The grantee (B) receives a deduction based on the
$10,000 as the gravel is extracted under the right.

Example 10.2 Issue
of a franchise

B issues a five year franchise to C for
an up-front payment of $30,000 together with royalties of 2 per cent of sales.

B is assessed on the up-front payment of $30,000, as the tax
value of the asset disposed of is nil and B is not eligible for the 50 per cent small
business capital gain exemption. The royalties are taxed on an annual basis.

The franchisee (C) receives a $6,000 deduction each year over the
five year life of the franchise.

Example 10.3
Easement

E grants a voluntary easement to F for
$100,000 over part of land which was acquired in 1986 for $500,000. The land is currently
valued at $1,000,000.

The tax value of E's land falls by $50,000, reflecting the 10 per
cent partial disposal of the land represented by the easement. E is taxed on
$50,000 -- the $100,000 receipt less the fall in the tax value of $50,000.

F is not allowed write-off for the expenditure, as the easement
is a perpetual right (the expenditure enters the tax value of the easement and would be
`deductible' if the easement were sold or terminated).

Example 10.4
Restrictive covenant

A agrees to buy a business from B
for $500,000, including $100,000 goodwill. B also grants a restrictive covenant to A,
agreeing not to compete with the business for the next five years. Pre-existing business
goodwill is commercially valued at $60,000 at the time the restrictive covenant is
created, giving a measurable value of $40,000 to the restrictive covenant.

B is taxed on the $40,000 measurable value of the restrictive
covenant, as the tax value of the asset disposed of is nil and B is not eligible for the
50 per cent small business capital gain exemption.

A receives a deduction of $8,000 a year over the five year life
of the right. If the restrictive covenant did not have measurable value, established at
the time the right is granted, the expenditure by the grantee would not qualify for a
deduction and the grantor would be taxed on the sale of goodwill associated with the
business.

That where non-routine rights in substance do not represent the disposal
of an asset, or part of an asset, the grantor be taxed on the following basis:

Term exceeding 10 years

(a) For rights of greater than 10 years:

(i) a balancing adjustment apply to the present value of payments for
the right as if it were a partial realisation of the underlying asset; and

(ii) the amount of the present value of the payments not assessed via
the balancing adjustment be assessed over the rest of the period of the right on the basis
of the write-off profile received by the grantee under Recommendation 10.3.

Term not exceeding 10 years

(b) For rights of 10 or less years -- no balancing adjustment
apply, with the present value of payments spread over the period of the right in line with
the grantee's write-off profile.

The grantor may regain the use of the underlying asset at the end of the right. This
would be the case with non-perpetual leases and rights over land and realty.

This categorisation would also apply to rights to remove standing timber from someone
else's land. In contrast to other rights to remove, the owner of the land can grant a
succession of rights over replanted timber on the same land. Especially in relation to
pre-CGT land, treating such rights simply as a part disposal would be a significant
concession.

With such rights, a balancing adjustment on disposal of the right should apply, in
principle, reflecting any previously unrealised changes in value associated with that part
of the underlying asset subject to the right. The balancing adjustment will be determined
as in the case of rights representing permanent disposals. Any portion of the present
value of payments for the right not assessed via the balancing adjustment will be assessed
over the period of the right - usually on the basis of the `mirror image' of the write-off
profile attracted by the grantee.

Without a balancing adjustment, it would be more attractive to grant long duration
rights than to sell assets. Treating rights as a part disposal of the underlying asset
avoids taxing any economic gains which are attributable to the part of the underlying
asset which has not been disposed of, and is consistent with the realisation treatment
which is applied to assets more generally.

This treatment will ensure that the value of the right is only taxed once over the
period of the right, with the timing of assessment depending on the extent of unrealised
gains associated with the underlying asset. Where there are no unrealised gains, all the
value will be assessed over the period of the right. Where (in the extreme case) the
payments reflect 100 per cent unrealised gains, all the value will be assessed at the
commencement of the right, with no subsequent further taxation (effects of delayed
payments aside).

This approach means that at the end of the right, the underlying asset would have the
same tax value as at the beginning, with unrealised gains which are taxed at the beginning
of the right effectively being returned to the grantor by the end of the right. Because
the unrealised gains are not permanently taxed, the income received through the partial
realisation at the beginning of the right will not attract capital gains treatment.

For simplicity, the Review proposes that there should be no partial realisation
associated with the granting of rights (which do not in substance represent the disposal
of an asset) for 10 years or a shorter period. The assessment of a payment received
up-front for a right will simply be spread over the period of the right, on the same basis
as the deduction by the grantee. This will reduce compliance costs associated with short
duration rights - particularly in relation to market valuation of the underlying
asset in order to determine the reduction in tax value of the underlying asset at the
start of the right and the associated balancing adjustment.

Example 10.5 A ten
year lease of a building and land

H leases a building
to J for ten years in return for an up-front payment of $75,000. The land and building
have a combined tax value of $200,000.

As the lease is for 10 years or less, there is no realisation
event associated with the lease. The lessee uses straight line depreciation and receives a
deduction of $7,500 a year over the ten year period. The lessor is also taxed on the basis
of the $7,500 a year over the ten year period.

Example 10.6 A
twenty year lease of a building and land

K leases a
building to J for twenty years in return for an up-front payment of $180,000. The land and
building were acquired in 1986 for $150,000. The current market value of the combined
building and land is $300,000.

The lessee elects to receive a straight line deduction of $9,000
a year over the period of the right.

The right effectively represents a 60 per cent realisation of the
value of the underlying asset. The tax value of the grantor's asset is therefore reduced
by $90,000 (60 per cent of the $150,000 cost base). The grantor is therefore taxed on a
partial realisation of $90,000 ($180,000 less $90,000) at the commencement of the right
and on $4,500 a year over the 20 year period of the right.

Example 10.7 Right
to remove trees from someone else's land

X buys some
land and trees for $80,000 and subsequently issues a right to remove the trees over a five
year period in return for a payment of $10,000 and a royalty of 10 per cent of the value
of timber when removed. The land and trees are jointly valued at $100,000 at the time that
the right is granted.

The grantor is taxed on the payment of $10,000 over the period of
the right -- ideally reflecting the profile of depletion of trees (and therefore
matching the basis of deductions taken by the grantee), with no partial realisation. The
royalty payments are taxed in the year that the timber is removed.

That amounts paid to non-residents for rights granted in relation to an
Australian asset be taxed on the basis of the character of the income from the right.

Under existing law, gains by non-residents on realisation or alienation of Australian
assetsare generally subject to Australian tax. Contrary to that intended outcome,
a non-resident can avoid royalty withholding tax by assigning to an Australian entity a
stream of royalties associated with an Australian asset in return for a lump sum payment.

In order to avoid potentially increased avoidance opportunities from the granting of
rights by overseas entities for up-front payments which are deductible to Australian
entities, amounts paid to non-residents for rights granted in relation to Australian
assets will be taxed on the basis of the character of the income from the right. In the
royalty example, the lump sum payment to the non-resident will be characterised as being a
royalty payment and hence subject to royalty withholding tax.

 are based on a realistic up-front estimation of the market
value residual of the asset at the end of the arrangement.

Exclusions from routine leasing

(c) That to limit access to the benefits of equal periodic rental
payments for lengthy leases over high value items, routine leasing exclude lease contracts
that for an individual unit of property involve:

(i) a value greater than $5 million if the contract is for a period
longer than 1 year;

(ii) a value greater than $1 million if the contract is for a
period longer than 3 years;

(iii) a value greater than $0.5 million if the contract is for a
period longer than 5 years; or

(iv) a period longer than 90 per cent of the effective life of
the asset.

(i) leases and rights over depreciable assets that are not `routine' be
taxed on the basis of the changing values of the associated assets and liabilities
(excluding leases of luxury cars); and

(ii) a balancing charge occur at the start of a `non-routine' lease
where used assets -- which have not been predominantly used for leasing -- are leased for
a period greater than half of their effective life for tax purposes.

The immediate focus of the Review is on the treatment of leases over depreciable assets
in the context of the Review's recommendation to remove accelerated depreciation.
Nevertheless, in the case of leasing it is imperative -- because of the potential for
tax benefit transfer -- to consider alternative arrangements, in the event
accelerated depreciation remains. Hence separate recommendations, including in relation to
leases involving tax exempts, are provided covering the circumstances of both removal and
retention of accelerated depreciation.

How equipment leases might be taxed in order to reflect more the economic nature of
transactions was discussed in A Platform for Consultation (Chapter 9,
pages 231-265). The present law does not provide the basis for taxing leases in a way
that appropriately reflects the changing values of the parties' assets and liabilities
under lease contracts. As a result, in some instances significant tax benefits can be
obtained from rear weighting lease payments, while tax disadvantages are associated with
up-front lease premiums.

The current lease treatment allows the transfer of the benefits of accelerated
depreciation between taxable lessors and lessees by way of lower lease payments (tax
preference transfer).

Two options for the taxation of leases were discussed in A Platform for Consultation
(pages 235-239):

 the `sale and loan' approach (Option 1) -- under which depreciation
allowances are taken by the lessee; and

 the `tax-preferred' leasing approach (Option 2) -- which
leaves the accelerated component of depreciation allowances with the lessor in order to
facilitate tax preference transfer via reduced lease rentals (for example, for lessees in
a tax loss position).

In submissions and during consultations with accounting, corporate and industry
representatives, there was some questioning of the need to deal with structuring of lease
payments because payments under most `routine' leases are spread evenly over the term of
the lease. It was suggested that deliberate structuring arrangements could be dealt with
by specific anti-avoidance rules.

The general view was that taxable lessors and lessees should be able to continue to
transfer the benefits of accelerated depreciation (assuming acceleration were to
continue).

Some concern was also expressed about the potential administrative and compliance
complexity in the `tax-preferred' leasing option discussed in A Platform for
Consultation.

The issues relating to the taxation of a lease or right over depreciable assets are
identical conceptually to those discussed earlier in relation to the taxation of rights
over non-depreciable assets. Thus, ideally, the tax treatment of leases over depreciable
assets should recognise the changing values of both the lease (which, in turn, reflects
the declining value of the underlying depreciable asset) and the stream of payments for
the lease (an asset to the lessor and a liability to the lessee). The declining underlying
asset may be a tangible depreciable asset or an intangible depreciable asset such as a
copyright, patent or registered design.

Such treatment would broadly parallel that proposed in Recommendations 10.3 and
10.5 for grantees and grantors of rights over non-depreciable assets -- in the
circumstances where they agree on a `demonstrated reasonable' estimate of the annual rate
of change in the benefits provided by the underlying assets. In the case of leases over
depreciable assets, the annual rate of change in underlying benefits would correspond to
the rate of depreciation of the assets.

Beyond these similarities between leases and rights, leases over depreciable assets
involve particular considerations in the following areas:

 accelerated depreciation for tax purposes -- a key issue identified
in Chapter 9 of A Platform for Consultation (pages 239-45)is
whether tax preference transfer (transfer of accelerated depreciation from the lessor to
the lessee via reduced lease rentals) should be permitted in relation to leases and
similar arrangements;

 the structuring of lease rentals -- under current
arrangements, even in the absence of accelerated depreciation, delayed lease rentals can
provide tax benefits to high marginal rate lessors (equal periodic rentals can provide
such benefits because of the decline in the benefit profile of the depreciable asset
subject to the lease); and

 potential tax advantages associated with balancing charge offset
and the lack of general debt forgiveness provisions -- these issues are discussed
under Recommendation 10.13 relating to lease assignments.

In the interests of simplicity -- and because of the relatively small revenue
implications of leases with equal regular payments -- the treatment of `routine'
leases will not differ substantially from their treatment under the existing law. They
will not be recognised as assets or liabilities under the generalised asset regime.

Under the new tax code, the lessor under a `routine' lease will be treated as holding
the depreciable asset and be entitled to depreciation allowances. The lessor's net income
will be increased by rental receipts from the lease, including specified rents due but not
paid at the end of the income year. A taxable business lessee will be entitled to
reductions in taxable income for rental amounts paid and amounts due but not paid.

Equal periodic lease rentals have the potential to involve excessive costs to tax
revenue when expensive depreciable assets are involved, particularly for long leases.
Hence, excluded from `routine' leases will be those over assets costing more than
$5 million (if the lease is for more than one year), or more than $1 million (if
the lease is for more than three years) or more than $500,000 (if the lease is for more
than five years) or those that are for periods longer than 90 per cent of the effective
life of the assets for tax purposes. This is illustrated in Figure 10.1. It will be
necessary to ensure that taxpayers are not able simply to disaggregate high value leases
into smaller components in order to qualify for `routine' lease treatment.

Figure 10.1 Routine leases for taxable entities

click
to enlarge image

Permissible length of 'routine` lease for given value of asset

Some administrative conditions will still be required to determine whether a lease is
involved or a hire purchase agreement (such as, no option to purchase by the lessee or
associate or provision of finance by the lessee). The exclusion from routine leasing of
high value items over longer periods, however, suggests that other conditions are not
necessary that are currently designed to stop revenue leakage associated with the
structuring of lease payments.

Under the recommendations, the only structuring of lease rentals permitted is the equal
periodic payments under routine leases. Should the routine lease specification prove too
broad (even with the exclusion of high value items), it would be preferable to extend the
structurally sound `non-routine' leasing arrangements further into the `routine' leasing
area to address the effect on tax revenue of equal periodic lease rentals rather than
imposing a range of arbitrary rules. Leasing by individuals and sale and leasebacks may be
relevant in this regard.

As noted below, the Review believes that tax preference transfer should be permitted in
relation to leasing between taxpayers (and the removal of accelerated depreciation would,
in any case, essentially remove this as an issue).

Should accelerated depreciation be retained, relaxing some current restrictions in
ATO rulings -- such as requiring at least 20 per cent `at risk' equity financed
by the lessor and that leases be `tax positive' over the period of the lease -- would
result in additional costs to revenue, as noted in A Platform for Consultation
(page 245). Relevant here, too, are current ATO arrangements that do not permit
individuals to be leveraged lessors of plant and equipment unless they are in `the
business of leasing' (an issue highlighted by any increase in the gap between the top
personal tax rate and the company rate). Similar, and indeed more severe, conditions apply
to leasing in most other countries, such as the United States and the United Kingdom.

Beyond blatant tax avoidance arrangements in the leasing area (such as leases that are
a series of `round robins') -- where the general anti-avoidance rule (GAAR) may have a
role -- the Review believes that structural solutions should be used to address
avoidance activity driven by flaws in the income tax base (Recommendation 6.2).
Accelerated depreciation is, however, a policy choice of government. The GAAR and specific
anti-avoidance rules should generally not be used to address the effects on tax revenue of
such policy choices. If excessive revenue loss is involved, the policy itself should be
adjusted. The case for specific anti-avoidance measures would have to be assessed against
the preliminary questions posed for this purpose in relation to
Recommendation 6.2(b)(ii).

The tax treatment of leases that involve significant specified structuring of the
profile of lease payments -- beyond regular equal payments -- or expensive
assets for long periods will reflect the changing tax values of the associated assets and
liabilities: either under a `sale and loan' treatment or under the general cashflow/tax
value framework. The choice between these two treatments depends on whether or not
accelerated depreciation is removed.

The `sale and loan' treatment, by formally transferring depreciation allowances from
tax lessor to the lessee, provides the benefits of accelerated depreciation to the lessee
at the lessee's tax rate. Those in a tax loss position would not, however, be able to
benefit immediately from any acceleration in those allowances. Were accelerated
depreciation to be retained in some form, the Review believes that tax preference transfer
should, in principle, be permitted in relation to leasing between taxpayers. Permitting
tax preference transfer for taxable lessees generally preserves the present position under
which taxable entities (including those in tax loss) are able to access the benefits of
accelerated depreciation through leasing. This places tax loss entities in the same
competitive position as entities which are able to benefit directly from accelerated
allowances. Thus, the `sale and loan' treatment is more suitable when accelerated
depreciation is not available.

In contrast, the general cashflow/tax value treatment would allow those in a tax loss
position to benefit immediately from tax preference transfer. In this case, the transfer
would be effected via reduced lease rentals, rather than by formal access by the lessee to
the accelerated allowances. This treatment would avoid the complexity associated with
dividing the depreciation allowances between the lessee and lessor that would have been
involved with the `tax-preferred' leasing option in A Platform for Consultation.

In the absence of accelerated depreciation, lease transactions not constituting a
`routine' lease will be treated for tax purposes under a `sale and loan' approach. The
lease is recast for tax purposes as a sale of the leased asset by the lessor to the lessee
financed by a loan from the lessor to the lessee. This is a simple, familiar method of
taking into account the changing tax values of the associated asset (the right of access
to the leased asset) and liability (any future structured lease rentals).

This approach therefore addresses in a structural way both the tax benefit and tax
disadvantage currently associated with structured lease payments. Neutrality is achieved
in the decision between leasing and borrowing to purchase the asset.

Cameo 9.1 on page 236 of A Platform for Consultation illustrated the operation
of the `sale and loan' treatment for a lease over a high value asset with equal annual
rental payments over five years. A similar example is reproduced in Example 10.8.

Where a lease or other right is not `routine' and does not apply to the whole asset
(for example, an indefeasible right of use over a submarine communications cable), sale
and loan treatment could be applied on a partial basis. Specification of the proportion
involved would be needed when the lease is over a period less than the life of the asset
in order to determine the value of the associated `loan'.

The general cashflow/tax value treatment again addresses in a structural way both the
tax benefit and tax disadvantage currently associated with structured lease payments. It
achieves neutrality in the decision between leasing and borrowing to purchase an asset,
regardless of the profile of lease payments, while also offering the opportunity for tax
loss lessees to benefit immediately from accelerated depreciation via reduced lease
rentals.

Consistent with the treatment of rights over non-depreciable assets, this treatment
takes into account the change in value of the lease to both the lessee and the lessor --
with that change in value reflecting the rate of effective life depreciation of the
underlying assets. In practice, the annual benefits from the lease are estimated by
equating the present value of the stream of lease rentals with a profile of benefits
declining at the depreciation rate. The changing value of the stream of lease payments is
also taken into account.

click to enlarge

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The operation of this treatment is illustrated in Example 10.9. The example
illustrates the same lease used in the `sale and loan' treatment of Example 10.8 in
the case where there is no accelerated depreciation. Should accelerated depreciation
remain, the mechanics of the general cashflow/tax value treatment would be the same as
shown in Example 10.9.

If accelerated depreciation remained, a balancing charge would be needed at the start
of the lease where used assets which are not being used predominantly for leasing are
leased for a sufficient duration -- say, a period greater than half the effective
life for tax purposes of the associated asset. That change maintains neutrality in the
decision to sell a currently owned asset (in which case a balancing charge will apply) or
lease it to someone else. The application of the balancing charge at the start of the
lease is equivalent in concept to the balancing charges recommended to apply on the part
disposal of long term rights over non-depreciable assets (Recommendation 10.5) and to the
disposal of benefits or obligations associated with financial assets and liabilities
(Recommendation 10.8(a)).

This treatment would handle any lease over part of a depreciable asset for any number
of years. Instead of the `sale and loan' treatment, it could also be used more generally
in the presence of accelerated depreciation.

Hire purchase arrangements (including cross border leases) and luxury car leases will
continue to be taxed on the basis of sale and loan treatment regardless of whether or not
accelerated depreciation remains. Under the existing law, hire purchase is used as a
mechanism to finance the purchase of depreciable property in a way that enables the asset
user to obtain the associated capital allowances, and also applies where there is an
effective option to purchase the asset. The existing law also treats lessees of luxury
cars as being entitled to capital allowances to ensure that the capital allowance
limitation on luxury cars is effective.

Sale and leaseback transactions currently offer the opportunity for owners to `refresh'
any accelerated capital allowances on depreciable assets while allowing the excess of the
`sale price' over depreciated value to be offset against the depreciated value of other
assets. The recommended removal of current balancing charge offset and adjustment rules
(Recommendation 8.11) will largely address this tax bias with sale and leaseback
arrangements -- although taxpayers in a tax loss position would not be immediately
affected by the balancing charge that will arise from a sale and lease back arrangement
when accelerated depreciation is available.

That section 51AD be abolished, as part of the package of reforms
including Recommendations 10.10 and 10.11.

Section 51AD currently denies all deductions relating to property predominantly
financed by non-recourse finance which is `leased to or effectively controlled by' a
tax-exempt entity.

Section 51AD has a severe impact where it applies because all deductions are denied to
the taxpayer but the associated income is still assessable. It has been continually
criticised by State governments and infrastructure providers for its severe impact where
it applies and the uncertainty it creates. Section 51AD has become even more problematical
in recent years because of increased levels of privatisation and outsourcing of government
services which were not contemplated when it was first conceived.

In A Platform for Consultation (pages 249 and 257) it was argued that the
severe treatment of arrangements that are currently prohibited by section 51AD is
unnecessary -- and there is no reason why leases (and similar arrangements) involving
tax exempts should be treated differently simply because they are financed using
non-recourse finance -- providing structural measures are in place to address
potential structured non-payment of non-recourse finance, tax preference transfer to tax
exempts and the timing advantages of delayed lease and service contract rentals.

The Review believes that section 51AD can no longer be justified. Structural measures
recommended to deal with extinguishment of liabilities (Recommendation 6.8) address
potential abuse of non-recourse finance through debt forgiveness. `Sale and loan'
treatment would also address this issue, as well as tax preference transfer and timing
benefits.

Thus, leases and similar arrangements involving tax exempts covered by section 51AD
will be broadly treated in the same manner as those currently subject to Division 16D. The
degree of complexity involved will depend on whether or not accelerated depreciation is
retained (Recommendations 10.10 and 10.11). Overseas use of assets (also presently
subject to section 51AD in some cases) will also be treated in a unified manner
(Recommendations 10.10 and 10.12).

Both industry and State government representatives strongly supported the abolition of
section 51AD and the development of a single, less severe provision to cover asset
financing arrangements involving tax exempts.

Abolition of section 51AD is recommended not as a stand-alone reform but as part
of the integrated reforms in this area reflected in Recommendations 10.9, 10.10 and
10.11.

That if accelerated depreciation (apart from that applying to small
business -- Recommendation 17.3) is removed:

(i) abolish Division 16D and tax leasing arrangements by tax exempts
broadly on the same basis as leasing arrangements between taxable entities -- as set
out in Recommendations 10.7(a)-(c) and 10.8(a);

(ii) for leasing arrangements involving tax exempts and offshore users,
narrow the class of `routine' leases by excluding such arrangements that would fall into
Recommendation 10.7(c)(i) -- that is, exclude lease contracts:

 involving units of property with a value greater than
$1 million; and

(a) State government tax exempts continue not to be allowed unrestricted
access to tax preferences under leasing arrangements.

Replacement arrangements based on `predominant interest'

(b) Division 16D be repealed and leasing and similar arrangements in
which a tax exempt has a `predominant interest' in assets involved in the arrangement be
included in the general `sale and loan' provision under Recommendation 10.8.

Defining `predominant interest' in assets

(c) Criteria for defining a `predominant interest' in assets:

(i) be established in consultation with State and Territory governments
and the private sector; and

(ii) apply to all tax-exempt entities, including entities which are
subject to Tax Equivalent Regimes.

Negotiating tax preference transfer to States

(d) The Commonwealth Government negotiate with the State and Territory
governments on the basis:

(i) of the in-principle position that State government tax exempts be
allowed access to tax preferences under leasing and similar arrangements;

(ii) that Recommendation 10.10 then apply; and

(iii) that offsetting adjustments to financial transfers between the
different levels of government be made to reflect the cost to revenue implied by (i).

The current Division 16D applies to arrangements involving the use or control of assets
by tax exempts where those arrangements are not financed by non-recourse debt. These
arrangements are therefore not subject to the more severe (and commonly encountered)
section 51AD. Division 16D applies to arrangements that are broadly similar to
finance leases.

Under Division 16D, these arrangements are recharacterised as the provision of loan
finance. Tax-exempt lessees are therefore denied the benefit of accelerated depreciation
on the assets. Division 16D is a form of `sale and loan' treatment but is complex in terms
of its drafting and has a number of technical limitations. As is the case with section
51AD, Division 16D applies where there is `effective control' of assets by tax exempts, a
concept which has been problematical.

If accelerated depreciation is removed (Recommendation 8.1), there will be no need for
complex provisions to determine which arrangements should be specifically subjected to
`sale and loan' treatment under the `predominant interest' test in
Recommendation 10.11(b). The increased simplicity of tax law and certainty for
taxpayers which would result in the tax exempt area is a further substantive argument for
removing accelerated depreciation.

There would nevertheless be significant benefits from equal periodic payments under
`routine' leasing between tax-exempt and taxable entities. There would be a significant
tax incentive to tax exempts to arrange `routine' leases over assets (including existing
assets) which they would otherwise purchase or hold themselves directly under existing
law. To illustrate, under an extreme assumption that all new assets of tax exempts were
leased under `routine' arrangements, the cost to revenue from structuring payments could
be up to $350 million by 2003-04. This cost would be increased by the sale and
leasing back of existing assets of tax exempts.

The scope of `routine' leases involving tax exempts therefore needs to be narrowed
significantly -- hence, the recommendation to exclude from the `routine' category any
leasing arrangement involving items of value greater than $1 million, regardless of
the length of the contract, as well as leases involving assets previously owned by tax
exempts. The resulting restrictions from `routine' leasing relating to high value items
are illustrated in Figure 10.2.

Figure 10.2 Routine leases for tax-exempt entities and offshore users

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to enlarge image

Permissible length of 'routine` lease for given value of asset

As with taxable leasing, if this lease specification of routine leases involving tax
exempts proved to be too broad, it would be necessary to extend further the structurally
sound non-routine leasing approach into the routine areas.

Structuring opportunities with service arrangements involving tax exempts would be
addressed by the application of the cashflow/tax value approach regime to those
arrangements -- consistent with the application of that regime to service arrangements
between entities generally. The application of this approach to arrangements involving tax
exempts would also benefit from consultation with State and Territory governments and
industry.

As noted earlier, the Review in principle supports tax benefit transfer effected by
leasing between taxpayers. Arguments in favour of allowing tax preference transfer
generally (including where tax exempts are involved) include making the benefits of
accelerated depreciation available equally to all taxpayers and tax exempts, improving
investment neutrality and competitive neutrality and reducing the complexity of the tax
system.

Arguments against allowing tax preference transfer in relation to tax exempts include
the financing bias that provides in favour of leasing and the significant cost to revenue.
In theory, the cost to revenue could be met by an agreement between the Commonwealth and
State and Territory governments which provided for offsetting changes in the level of
transfers between the different levels of government.

State government and industry representatives considered that, over the time horizon
encompassed by the Review, the complexities associated with reaching an agreement between
the Commonwealth and State and Territory governments mean that the option of permitting
tax preference transfer in relation to tax exempts is unlikely to be feasible. The
argument was also put that it is impossible to quantify the effect on Commonwealth and
State and Territory finances of allowing unlimited tax preference transfer to tax exempts
and, hence, it was preferable to continue to restrict access to tax preferences.

The Review believes that it is appropriate in the short term to continue to restrict
access by tax-exempts to accelerated depreciation should that remain, given the cost to
revenue of allowing tax preference transfer and the difficulties associated with reaching
a suitable agreement between the Commonwealth and the States and Territories to address
the costs.

The Review also believes that, given its deficiencies, Division 16D should be replaced.
However, application to tax exempts of the improved replacement will still necessarily
remain relatively complex and uncertain, given the inherent complexities associated with
determining the boundary line between those arrangements where tax preference transfer
should be restricted and those where it should not.

If accelerated depreciation allowances were to be retained, the Review considers that
there would be benefits in the Commonwealth and State and Territory governments entering
into negotiations about addressing the costs to revenue associated with allowing tax
preference transfer to tax exempts through offsetting adjustments to financial transfers
between the different levels of government.

The Review recognises the great practical difficulties that would be involved in
assessing the cost to revenue from allowing tax preference transfer and in assessing the
distribution of the benefits among the States and Territories. Nevertheless, the Review
recommends that should accelerated depreciation provisions remain, the Government enter
into negotiations because, if such an agreement could be reached, there would be no need
for complex provisions to determine which arrangements involving tax exempts should be
specifically subjected to `sale and loan' treatment. The arrangements in Recommendation
10.10 would apply. This would significantly reduce tax law complexity.

Both State and Territory governments and private sector representatives argued that tax
preference transfer should be permitted where the end user of an asset is a Government
Trading Enterprise (GTE) which is subject to a Tax Equivalent Regime (TER). State
government representatives also argued that permitting tax preference transfer to entities
subject to TERs is consistent with the principles of National Competition Policy.

State and Territory governments also argued that a reciprocal arrangement between the
Commonwealth and the States and Territories to allow tax preference transfer between
taxable entities and entities subject to TERs will not, a priori, involve any cost
to Commonwealth revenue. They suggested that deductions being taken by taxable entities in
relation to assets used by GTEs would, as likely as not, be balanced by deductions being
taken by TER entities in relation to assets used by taxable entities.

The nature of GTE operations means that they are more likely to be lessees of assets
rather than lessors of assets to taxable entities. Although, at the moment, TERs do not
fully mirror Commonwealth tax, it is intended that a national tax equivalent regime be
operational for State and Territory GTEs from 1 July 2000.

It remains the case that, notwithstanding independence of GTEs from their State and
local government owners, it will be more beneficial from their owners' point of view if
GTEs were to access Commonwealth tax preferences through leasing than to access tax
preferences provided by their owners through the TER.

Around 50 per cent of total annual investment in depreciable plant and equipment by the
tax exempt sector is currently undertaken by State and local government GTEs. Providing an
exemption for TER entities from the restriction on tax preference transfer to tax exempts
would therefore involve a substantial proportion of the cost of allowing tax preference
transfer. Such an exemption could also create an incentive for tax exempts to undertake
more of their investment through TER entities.

The Review proposes that, under the revised arrangements, tax preference transfer
should be restricted in relation to arrangements involving all tax-exempt entities, not
just public tax exempts as under the current Division 16D. Similar issues arise in
relation to tax exempts which are not public entities as with those that are. The revised
provisions should therefore apply equally to all tax exempt entities. This is similar to
the current coverage of section 51AD.

A Platform for Consultation (page 262) suggested that, based on experience
with section 51AD and Division 16D, restrictions on tax preference transfer to tax exempts
should not be based on the concept of which entity `controls' the asset. Instead, the
Review suggested that the criteria for the restriction should be based on the extent to
which the tax exempt has equity risks and benefits in the asset.

Four options were canvassed for determining when a tax exempt had sufficient of the
risks and benefits of an arrangement to justify denying tax preference transfer. These
were:

 including only those arrangements which were similar to finance
leases;

 including those arrangements where the tax exempt had the
`predominant' interest (or majority interest) in the underlying asset;

 including essentially all arrangements which represented the
provision of finance, subject to specific exclusions; and

 denying deductions in proportion to the degree to which the tax
exempt was `at risk'.

During consultations, State government representatives and industry supported a
framework which it was agreed could form the basis for developing criteria to be used to
determine arrangements subject to the `sale and loan' treatment. Under the proposed
framework, an arrangement will be subject to the `sale and loan' provision when the tax
exempt holds the `predominant interest' in the arrangement (or the assets involved in an
arrangement).

Provisionally, it is proposed that a tax exempt's `predominant interest' in an
arrangement would be established through a `two tailed test'. The tax exempt would be
deemed to have a predominant interest if:

 an indicative list of relevant project risks suggests that
sufficient risks were being borne by the tax exempt; or

 quantification of the financial burden of the risks of the
arrangement to the extent possible (using a methodology which will need to be developed)
indicated that over a threshold proportion of between 50 and 75 per cent of the risks
were borne by the tax exempt.

When quantifying the financial burden of the risks, a threshold of over
50 per cent was favoured by State government representatives on the basis that
it provided for a margin of error necessarily inherent in any methodology to quantify the
aggregate burden of the risks. This test could be applied both to cases in which the tax
exempt has a predominant interest in arrangements where assets are owned by taxable
entities, and also to cases where the tax exempt is the owner and leases the asset to a
taxable entity -- although developing criteria that both provide sufficient
protection for the revenue and also provide some certainty and ease of compliance for
taxpayers and tax exempts could prove difficult.

That access to any accelerated depreciation allowances be prevented
where assets are used offshore, except where the assets are `primarily used for
non-leasing purposes' by an Australian taxpayer.

A Platform for Consultation (pages 245-6) noted that where Australian-based
lessors lease assets to overseas users, the benefits of any accelerated depreciation
allowances can be passed to the overseas lessee if tax benefit transfer is permitted. If
the purpose of accelerated depreciation allowances is to increase the level of such
activities in Australia, this is not appropriate.

Where Australian businesses such as airlines and shipping firms are the end users of
assets used outside Australia to generate assessable income in Australia, it is
appropriate to allow them to access tax preferences in relation to these assets in the
normal way. However, in a world of increasingly globalised operations, it can be difficult
to be sure that an Australian business is the `end user' of an asset and has not instead
effectively transferred use to an overseas business.

Some industry representatives argued that there should be no restrictions on the
overseas operations of assets which form part of an Australian business. However, other
industry representatives accepted that there was a need to delineate circumstances in
which overseas use of assets should not attract Australian tax preferences.

The preferred approach to addressing the issue of overseas use of assets is to have
Australian tax preferences only available in relation to overseas use of assets when an
Australian business is the `primary user for non-leasing purposes' of the asset. Under
this test, Australian business will be able to access Australian tax preferences in
relation to overseas use of assets if, during a relevant period, an asset is primarily
used for non-leasing purposes by that business.

The test could be constructed so that it not apply where assets were temporarily used
for leasing purposes by an Australian business because of unforeseen circumstances (such
as during economic downturn).

The intention behind the test is not to hinder sound commercial practice in relation to
assets that are used in the ordinary course of trade by an Australian business, but to
prevent tax preferences being taken where assets are effectively leased by Australian
businesses (or financiers) to overseas users.

Such a test could apply in more cases than under the current Division 16D, which only
applies to finance leases, but would be significantly less severe than the test which
currently applies under section 51AD in relation to arrangements which are financed using
non-recourse finance.

Development of the test, and its application in practice, will involve additional work
and consultation with industry representatives. The test would not be required if
accelerated depreciation allowances were abolished (Recommendation 8.1).

(a) That the consideration received on assigning a lease (or an interest
in a leased asset) on or after 22 February 1999:

(i) be included in the taxable income of the assignor; and

(ii) include all relevant benefits, including any associated debt or
liability from which the assignor is relieved.

Disposal of majority interest in leasing subsidiary

(b) That where a wholly owned company group sells or transfers to
another entity not in the same business as the company group, on or after
22 February 1999, a majority beneficial ownership in a subsidiary that is
predominantly used to lease assets:

(i) the leased assets held by the subsidiary be treated as being
disposed of and re-acquired at market value;

(ii) balancing charge offset not apply to reduce the taxable balancing
charge arising from the deemed market value disposal; and

(iii) the former group be liable for the tax if the former subsidiary
does not pay the associated tax within six months of the due date.

Asset or equity assignment upon lease termination

(c) That the measures in paragraphs (a) and (b) also apply in the
circumstances where the relevant lease is terminated and the asset (or subsidiary)
assigned rather than the pre-existing lease.

Qualifying period for disposal of majority interest

(d) That paragraph (b) only apply to an asset which:

(i) was a leased asset on or after 22 February 1999; and

(ii) had been leased for a majority of the period it was held by the
assignor or an associate prior to disposal of the asset or subsidiary.

These lease assignment measures will apply to arrangements entered into after
22 February 1999. In a press release of 22 February 1999, the Treasurer
gave notice that the Government reserved the right to take such action as was necessary to
address any exploitation of deficiencies in the current business tax system in the period
between the release of A Platform for Consultation and when legislation on a
new business tax system is enacted. Lease assignments were specifically raised as an area
of concern in this regard in a letter of 22 February 1999 from Mr Ralph to the
Treasurer on that day (and referred to in the Treasurer's press release of that date).

In Chapter 8 of A Platform for Consultation (page 221) it was explained that tax
can be avoided on some lease transactions through assigning (or selling) leases along with
associated debt liabilities to a tax exempt or low tax rate taxpayer.

The following aspects of the existing law facilitate tax avoidance through lease
assignments:

 The current structurally unsound treatment of the changing values
of the assets and liabilities associated with the leasing of depreciable assets. Even in
the absence of accelerated depreciation, the current poor treatment encourages delayed
rental payments to the benefit of high marginal tax rate lessors -- and results in no
tax being paid in the early part of the lease because depreciation and debt interest
deductions (at high tax rates) exceed the lease income. This produces a `lease tail' of
lease rentals and outstanding debt ready for assignment by the lessor.

 Where debt obligations have been assigned along with the leased
asset, the benefit of being relieved of the debt is not brought to account as part of the
assignment proceeds.

 Assignors are able to avoid tax on balancing charges -- essentially
recoupment of depreciation -- when the leased asset is disposed of, by taking advantage of
a balancing charge rollover rule which applies where there is only a partial change in the
ownership of an asset (such as a change in interests in a partnership). The effect of the
rollover is that tax is permanently avoided, as the new partner is a tax-exempt or low tax
entity.

Structural measures recommended by the Review -- including reformed treatment of
non-routine leases (Recommendation 10.8), changes to partnerships (Recommendation 16.16)
and taxation on extinguishment of liabilities (Recommendation 6.8) -- could, if
adopted, largely remove the scope for obtaining unintended tax benefits from assigning new
leases after the commencement of these new arrangements (see A Platform for
Consultation, pages 250-251).

There will, however, be opportunities to assign leases prior to these structural
measures being enacted, and there would be continuing opportunities for gaining
unwarranted tax benefits in relation to lease transactions in place before that time.

The exploitation of lease assignments can also be achieved by selling the entity that
holds the leased asset (or an interest in a leased asset) to a low tax entity rather than
assigning the lease. Gains and losses on assets are reflected in the value of interests in
the entities that own those assets. As the value of the shares in an entity represents the
value of its assets net of liabilities, there is an effective realisation of the value of
the assets by the transferor of the shares.

By selling the entity that owns the assets, a transferor can also avoid the application
of a balancing charge that would have applied if the assets were sold. This is
particularly relevant where the entity that holds the assets is a wholly owned subsidiary
in a corporate group because the benefits of accelerated depreciation can be transferred
to the holding company prior to the subsequent disposal of the subsidiary.

Recommendation 10.13(b) is therefore intended to address situations where
unwarranted tax benefits are obtained by assigning an entity rather than a direct interest
in a leased asset, and is needed as an integrity measure. In order to target the measure,
it will only apply to sales of wholly owned subsidiaries that are predominantly used to
lease assets and where the sale is to another entity that is not in the same business as
the company group. This will mean that legitimate transfers of interests to similar
businesses will not be affected.

In some circumstances a lessor company that has been degrouped may not have the funds
to pay the tax liability arising, as the benefits have been previously taken by the group.
It is therefore reasonable to require the former group to pay the tax if the former
subsidiary does not pay within six months of the due date for payment.

With both direct lease assignments and sales of leasing subsidiaries, it is necessary
to ensure that the measures are not avoided by prior termination of the leases --
Recommendation 10.13(c). To target this additional measure -- Recommendation 10.13(d)
-- it will apply only to assets which were leased on or after 22 February 1999
and which were leased for a majority of the period that they were held by the assignor or
group prior to disposal of the asset or associated subsidiary.

Some stylised examples of a lease assignment and how the proposed measures will apply
are shown below.

Example 10.10
Lease assignment where debt obligations are not currently assessed

Current
treatment

The assignment of a lease to a tax-exempt entity relates to a
five year leveraged lease over a $100 asset. The lessor finances the lease with a $100
loan which is repaid over the lease. Accelerated depreciation provisions allow the asset
to be written off over three years. Equal annual lease payments are made by the lessee,
which provide the lessor with enough after-tax cash flow to just cover the repayments of
the loan plus interest over five years.

After three years the accelerated depreciation allowances are
exhausted and the lessor's taxable income is positive for the rest of the lease.

At the point of assignment (after three years) for nil dollars,
the asset is worth $40 and the size of the loan is also $40. The lease is cash flow
negative for the lessor -- that is the value of the lease payments to come is less than
the value of the debt which needs to be repaid plus the tax liability.

Current treatment

Cash consideration $ 0

Debt obligation effectively transferred $40

Taxable consideration $ 0

Proposed treatment

Under Recommendation 10.13(a) where the taxpayer assigns a leased
asset to a tax exempt, the debt obligations from which the assignor is relieved ($40) will
be included in the taxable income of the assignor.

Current treatment

A partner who holds a 50 per cent interest in a special purpose
lease partnership assigns the interest to another entity. The partnership holds the asset
described in Example 10.10. The assignor avoids tax on any balancing charge through
the rollover rule which applies where there is only a partial change in the ownership of
an asset. Where balancing charge rollover is elected, the consideration on assignment is
currently not taxable regardless of whether payment is made in the form of cash or
relinquished debt.

Cash consideration for the assignment $40

Depreciated value of the leased asset $ 0

Partner's share of the depreciated value $ 0

Total assessable amount $ 0

Balancing charge if the partner sold the asset $40

Proposed treatment

Under Recommendation 10.13(a) any consideration received on
assignment will be included in the taxable income of the assignor.

Current treatment

Where a wholly owned company group ceases to hold a majority
beneficial ownership in a subsidiary that has been established to lease assets, the
transferor can avoid the application of a balancing charge that would have applied if the
assets were sold. The benefits of accelerated depreciation can be transferred to holding
companies prior to the subsequent disposal of the subsidiary. Again the asset in
Example 10.10 is held by the leasing subsidiary that is sold.

Market value $40

Depreciated value $ 0

Total assessable amount $ 0

Balancing charge if the company sold the asset
at market value $40

Proposed treatment

Under Recommendation 10.13(b) the leased assets held by the
subsidiary will be treated as being disposed of and re-acquired at market value. Balancing
charge offset will not apply to reduce the taxable balancing charge arising from the
deemed market value disposal. This reflects the fact that the former owners of the company
have effectively disposed of their interest in the assets held by the company. The
re-acquisition rule means that the company (in the hands of the new beneficial owner) can
depreciate the asset on the basis of market value, but the seller of the subsidiary is
assessed on the same basis as if the subsidiary sold the asset.